John D. Colombo, In Search of Private Benefit

INTRODUCTION:: For at least the past two decades, the Internal Revenue Service (IRS) has relied heavily on the private benefit doctrine to police economic transactions between tax- exempt charities and for-profit entities. The doctrine has been used to regulate the size of the charitable class needed to justify exemption, prohibit joint-venture transactions between nonprofits and individuals or for-profit entities, regulate employee recruiting, and possibly serve as a substantive constraint on contracts with third parties. Despite the IRS’s broad invocation of private benefit as a policing tool, however (or perhaps precisely because of its broad invocation of it), no one really can define the doctrine. The only thing close to an official definition comes from an IRS General Counsel’s Memorandum issued in 1987, which noted that:

An organization is not described in section 501(c)(3) if it serves a private interest more than incidentally . . . .

A private benefit is considered incidental only if it is incidental in both a qualitative and a quantitative sense. In order to be incidental in a qualitative sense, the benefit must be a necessary concomitant of the activity which benefits the public at large, i.e., the activity can be accomplished only by benefitting certain private individuals . . . . To be incidental in a quantitative sense, the private benefit must not be substantial after considering the overall public benefit conferred by the activity.

This is a quintessential balancing test under which the IRS both owns and reads the scale, leaving charities completely at sea regarding the possible ill effects of transactions with for-profit entities. But the larger problem is that no one even knows what to balance, since practically any transaction undertaken by an exempt charity will result in benefit to some private party outside the charitable class. For example, when the Salvation Army buys food to feed the homeless, food retailers profit from the sales. Ditto for the trailer manufacturers or hotel operators that benefit when the Red Cross provides temporary shelter for disaster victims. We all assume these transactions fall into the “incidental” category and do not result in private benefit problems. But one court decision proclaimed that a “secondary” private benefit flowing to a major political party, as a byproduct of an exempt educational organization that trained political campaign operatives, was not incidental, and to date only one academic has attempted a more comprehensive explanation.

In an attempt to provide some additional clarity to the doctrine, in September 2005 the IRS proposed regulations that would add some examples to Treasury Regulation § 1.501(c)(3)-1(d)(1)(ii) to illustrate the application of the private benefit doctrine. These examples, however, are as widely varied as the IRS’s previous invocation of the doctrine and seem at first glance to offer little in the way of guidance concerning what the doctrine means and when it realistically becomes a transactional problem.

In the past I have expressed my displeasure with the private benefit doctrine in writing, explicitly calling for its demise. But I have come to accept that (1) the doctrine isn’t going away, (2) it is unreasonable for me to ask the IRS to simply abandon an effective policing tool, and perhaps most importantly, (3) a properly-defined private benefit doctrine has a place in analyzing how exempt entities interact with for-profit entities or individuals. So in place of my past position of “just get rid of it,” this Article attempts to identify both a specific rationale for the private benefit doctrine and the paradigm transactions to which it should apply.

Specifically, the Article suggests that the private benefit doctrine should be invoked in cases in which transactions carry substantial risk that the charity is “failing to conserve” charitable assets for the charitable class. I identify two paradigm situations in which the risk of such failure to conserve may be especially high: (1) A charitable entity transacts with an individual or for-profit entity in order to provide “core services” (services that form the basis for tax exemption) to the beneficiaries of the charity (the “outsourcing” paradigm), or (2) the charity enters into a transaction with a for-profit entity or individual involving these core services that confers a competitive advantage on the for-profit in its own business activities (the “competitive advantage” paradigm). In situation (1), the failure to conserve may be the result of paying a profit margin to the for-profit entity to perform services that the charity might be able to provide as efficiently (or more efficiently) directly. In situation (2), the failure to conserve may be the failure to capture the full value of the competitive benefit conferred by the charity on the for-profit. In either situation, the charity should be required to present a reasonable justification that the transaction in question does not “waste” charitable resources in order to maintain the charity’s tax exemption.

Since this Article calls for a considerably narrower application of the private benefit doctrine than has recently been the norm, I suspect that when I am done, the IRS may be no happier with my new found appreciation for private benefit than with my prior disdain for it. On the other hand, perhaps recent events, particularly the IRS’s promulgation of Revenue Ruling 2004-51 regarding ancillary joint ventures, evidence a new willingness by the IRS to re-examine its use of the private benefit doctrine.